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The risk premium and long-run global imbalances

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  • YiLi Chien
  • Kanda Naknoi

Abstract

Our paper investigates whether the valuation effect caused by a large risk premium and a low risk-free rate can help to explain the enormous US current account and trade deficit observed in the past decade. To answer this question, we set up an endowment growth model in which investors are endowed with heterogeneous trading technologies. In our model, the average US investors load up more aggregate risk by investing in a risky asset abroad and issuing a risk-free asset. Thanks to the large risk premium as well as the low risk-free rate, the US can sustain a long-run trade deficit even as a debtor country. Quantitatively, we find that the valuation effect caused solely by the high risk premium and the low risk-free rate in our model, which is calibrated to match the external assets and liabilities of the US economy, can account for more than half of the observed trade deficit and current account deficit. Our results suggest that the current US trade deficit might not necessarily lead to net export increases or dollar depreciation in the future.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2012-009.

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Date of creation: 2012
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Handle: RePEc:fip:fedlwp:2012-009

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Keywords: International trade ; Risk management;

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Cited by:
  1. Zhiwei XU & Yi Wen & pengfei Wang, 2013. "Two-Way Capital Flows and Global Imbalances: A Neoclassical Approach," 2013 Meeting Papers 406, Society for Economic Dynamics.

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